Top 10 Red Flags That Trigger IRS Audits

The good news is that, on the average, very few people get audited by the IRS. Better still for some of us, the less money you make, the less likely you are to be audited. According to the IRS, for Tax Year 2009, if you made less than $200,000, you had a slightly lower than 1% chance of being audited. If you made more than $200,000, your odds jumped to almost 3%. If you earned over $1 million, bump that frequency up to over 6%.

The bad news is that the chance still exists for all of us, and despite the general professionalism of the IRS, an audit is rarely a pleasant experience. To avoid audits, stay clear of these top 10 things that raise red flags with the IRS.

1. Math Problems

Your income tax return gets entered into an IRS computer, one way or another. If you have made a math error, you will automatically get the computer’s attention. This is why, if you do your own return, it may be a good idea to run it through a tax program to check your math.

2. Match Game

Another simple way to get the IRS computer’s attention is to report income differently on your return than the people who pay it to you report it, via W-2s and 1099s. The IRS computer will try to match all of your payers’ numbers with your numbers, and when they can’t, you get a letter. So gather all of those envelopes stamped “IMPORTANT - TAX RETURN DOCUMENTS,” and tick off all of those numbers.

3. Not Just How Much, But Also How

As I noted above, your income level can affect your odds of being audited, but how you earn that income is also relevant. People who work in jobs where a significant amount of unreported cash changes hands, such as restaurant wait staff or salon workers, garner more interest.

4. The Boss of Me

People who own their own (unincorporated) businesses are responsible for reporting their own income and expenses on Schedule C. While some of their income can be cross-checked with 1099s, they are on the honor system for the rest of their income and all of their deductions. Until such time as the IRS decides to check up on them, that is. Because there is room for abuse, the IRS checks these returns more frequently. (See also: When and How to Incorporate: A Guide For Sole Proprietors)

5. In the Hole

People who own their own businesses and report a net loss, rather than net income, merit even more attention. That is especially true if they are also a full-time W-2 wage earner. This is because you are allowed to deduct a loss from your legitimate business, but you are NOT allowed to deduct a loss from your hobby. If you are a W-2 wage earner who also reports a business loss, it looks like you might just be deducting your hobby expenses. (Keep in mind, though, if you have net hobby income, you must report that.)

6. Let’s All Be Reasonable

While reasonableness seems like a subjective, innately human issue, the IRS computers are capable of making at least a preliminary judgment of it. In fact, they make a practice of doing just that. With complex statistical formulas, they look at the reasonableness of your deductions as they relate to your income. If they seem out of line, your return gets a second look by a human being. So, if some or many of your deductions seem unusually large for someone with your income, prepare for an inquiry.

7. Isn’t That an Oxymoron?

The IRS seems to think so, about the “home-office” deduction. It was once an area of considerable abuse, which always leads to a crackdown. The IRS Code stipulates such strict rules for the home-office deduction that few people qualify for it. When it shows up on a return, the odds that the return will be examined are substantially increased. (See also: The Home Office Deduction Guide)

8. In Round Numbers

Tax returns rife with round numbers smack of estimations. When people estimate, they usually err in their own favor—you do the math. No, really, do the math, and put specific numbers on your return; not estimates.

9. Driving All Out

Numbers can sound good attached to cars—The Beach Boys sang 409 about a souped-up Chevrolet; The Brian Setzer Orchestra had their ’49 Mercury Blues; Sammy Hagar sang, I Can’t Drive 55—but one number that hits a real clinker for the IRS is 100%, particularly when it represents the business use percentage you claim for your automobile. That means you must never drive it to commute back and forth to work, or out to lunch, or to the grocery store. Maintaining 100% business usage of a vehicle is virtually impossible. It’s another round number that just doesn’t harmonize very well with your tax return. (See also: Tax Guide for Business Use of Vehicles)

10. That’s Entertainment!

Yet another area of common abuse is that of meals and entertainment. So much so, apparently, that Congress saw fit to arbitrarily limit your deduction by half back in the 80s. So for every dollar you spend on legitimate business meals and entertainment, you derive a 50 cent deduction. Nonetheless, the deduction is still overused, and therefore an area of heightened interest to the IRS.

Reporting information on your tax return that results in your being audited doesn’t necessarily mean you have done anything wrong. Many CPAs will tell you that you should not allow the fear of an audit prevent you from taking legitimate deductions. However, knowing the kinds of things that are likely to increase your odds for an audit allows you to make decisions about the potential costs and benefits of certain deductions.

I talked to my accountant and asked him to confirm that Schedule C filer audits were way up. He said for sure, as well as S-Corps and LLCs, and that no small business was immune from increased scrutiny.

So I asked him basically if you were a small business, there is no benefit to incorporate or form an LLC for the sole reason to decrease your chances to get an audit.

Good point, Dan. As you imply, though there may be other good reasons to organize a business as other than a sole proprietor, overall audit avoidance isn’t one of them. My point was only that the individual return filer’s odds go up with a Schedule C over, say, a W-2 wage earner’s odds. Alas, some things just can’t be avoided.

R.F. #5

I wish the odds of winning the lottery were as good as getting audited! (Of course, that would probably be a red flag, too!)